The Dirty Little Secret Of Basel III

While the Basel III rules for bank capital significantly raise the amount of capital banks will be required to hold, the new rules do nothing to address a little known problem that was at the very heart of the financial crisis.

To begin, the big banks and securities firms that failed during the financial crisis had capital buffers even higher than those that will be required by Basel III.

“The five largest US financial institutions subject to Basel capital rules that either failed or were forced into government-assisted mergers in 2008 — Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch — had regulatory capital ratios ranging from 12.3 per cent to 16.1 per cent as of their last quarterly disclosures before they were effectively shut down,” Andrew Kuritzkes and Hal Scott have explained.

The heart of the crisis was not so much under-capitalization of a few risk taking financial institutions. It was over-correlation. So many of our banks fell into trouble all at once because their balance sheets were so heavily loaded with mortgage backed securities. In 2005, for example, banks owned 45 percent of all subprime mortgage backed securities. Prior to the crisis, bank exposure to mortgage backed securities was three times as high as the other, non-bank US investors, according to political scientist Jeffrey Friedman’s forthcoming book “Engineering The Perfect Storm.”

Why did our banks own so many mortgage backed securities? The answer seems to be the relative risk weighting assigned to highly rated mortgage backed securities made it extremely costly to avoid the mortgage market.

In 2001, the US banking regulators jointly put forth an amendment to the Basel Accords that changed the way banks calculated capital set asides. Different types of investment were assigned different risk weights, requiring different amounts of capital reserves. The new rules said that for every $1 million of mortgage backed bonds, banks had to reserve $2,000. One million dollars of non-securitized mortgage loans required a $5,000 reserve. A million in commercial loans required a $10,000 reserve.

Since reserve capital is dead money for banks, they try to minimize the amount they need to set aside. Thanks to the risk weighting , banks were heavily incentivized to put money into mortgage-backed securities. They specifically sought highly rated subprime because that maximized the risk-weighted yield. Some 93% of the mortgage backed securities owned by commercial banks were rated AAA or issued by a GSE, Friedman estimates.

The problem is not just that the ratings and the risk weightings under-estimated the risk of these bonds. It’s that the unified measure of risk and centralized requirement for capital reserves result in banks with highly correlated business strategies—buy mortgage bonds!—and very similar balance sheets—lots of mortgage bonds!

This was why the housing downturn led to a banking crisis. The capital reserve rules had led to correlated risk throughout the banking sector. Instead of a diversity of banks following different strategies, they were crowded on one side of the trade.

The new Basel rules do nothing to address the problem of correlated risk. From what we can tell, this source of systemic risk played no part at all in the negotiations in Switzerland. So our system is just as vulnerable as it was to correlation risk.